Prepayments in February continued to reduce the outstanding quantity of 6.5s and up, further changing the coupon distribution in the mortgage market. With rates so low, the market is seeing increased production in 30-year 5s and even some issuance in 15-year 4.5s, which is noteworthy given that, just a year ago, there was barely any 5.5s production.

"One thing that happened this week is 30-year 5s are starting to become a more actively traded coupon and more actively originated by mortgage bankers," said Art Frank, head of mortgage research at Nomura Securities International last Tuesday. "This interest rate environment resulted in 5.5s to 7s becoming more compressed."

However, despite the resulting compression in premiums, Frank added that the significant growth in 30-year 5s and the appearance of 15-year 4.5s would alleviate this problem somewhat. "To the extent that these coupons keep getting originated and get more liquid, this would expand the coupon stack a little bit, which is a healthy sign for the mortgage market at these rate levels," he said.

As lower coupons make up a greater share of the market, the coupon stack is changing quite dramatically. Just a year ago, there were no 30-year 5.5s to speak of, said analysts from RBS Greenwich Capital. In direct contrast, 5.5s currently comprise 16% of outstanding Fannie 30-year ones.

Meanwhile, 6.5s (because of the large amount of seasoned paper issued during the 1993 and 1998 rallies) remain the largest coupon outstanding. Currently, paydowns in 6s and up are probably moving into 5s, 5.5s and 6s. Greenwich analysts expect 6s to become the largest coupon in the next prepayment report, while 5.5s will likely have the strongest relative growth and 5s will probably join the list as well.

Spotlight on 5s

"The beginning of production in 30-year 5s implies that the share of 5.5s should be declining," wrote analysts from JPMorgan Securities. "We expect that by May, 5.5s will only be growing at around 1.5% a month while the share of 5s reaches over 0.5%, rising to over 1% by June."

If rates remain where they are right now (or dip), 30-year, no-point mortgage rates are likely to drop to 5.5% by April, which would lead to a spate of 5s in June production. Further, the 15-year primary mortgage rate will probably drop to around 4.75%. This would likely push origination in Dwarf 4s for June and drive speeds on Dwarf 5s well above 25% CPR by June.

Because of this sudden spike in issuance in 5s, the market is now looking closely at this particular coupon. With the whole market currently trading above par, 5s have now become the "discount coupon" because it carries the lowest price in the 30-year coupon stack, said analysts from Countrywide Securities in a recent report. Issues with 5s, however, should be addressed.

From an issuance perspective, origination in the coupon has picked up over the last one and a half weeks. In terms of issuance going forward, an examination of figures from the fourth quarter of last year - specifically at the production of 5.5s for this period - would give some indication of what to expect from conventional 5s in upcoming months, said analysts.

Data showed that 5.5s as a percentage of total 30-year production stayed relatively small until November 2002, when it actually went over 6% issuance. Assuming that last fall's precedent is followed, issuance in 5s should show a similar pattern in the next few months.

If rates remain at these levels, analysts predict market share of 5.5s will level off in the area of 50% to 60% of production later in the spring. Meanwhile, 5s should comprise 20% to 30% of issuance, leaving 6s to decline to about 10% to 20% and 6.5s to dip to less than 3% of conventional issuance.

Analysts also looked at how 30-year 5s should perform under different interest rate scenarios. If the bond market continues to rally, the demand for this coupon should increase as investors would likely move down in coupon. Conversely, issuance should pick up significantly, so originators will be selling the coupon in the back months. There probably will be some pair-off buying of 5.5s by originators trying to replace the expected production of 5.5s with 5s.

This is why Countrywide said that 5s could temporarily underperform 5.5s, specifically in the back months. Analysts thus suggest that bullish investors should buy 5s on weakness in the front months.

In a market selloff, 5s are also expected to underperform since this coupon has a considerably longer duration than 5.5s and other 30-year coupons. A look at how the 6/5.5 swap performed last fall shows that the market gets comfortable with a new low coupon in stages. If conventional 5s follow this pattern, analysts expect 5s to perform poorly the first time the market sells off from current levels. But after the market builds a base and is tested through a mini-cycle, the coupon could actually hold its ground much longer during a selloff.

No reversal even with Fed ease

Even with the Fed futures market pricing an ease in the next couple of months, there will not be a meaningful reversal of the coupon compression in MBS, said JPMorgan Securities analysts, who have been pushing this theme for some time now.

"Prepayments are now the main driver of coupon compression-rates are at levels where a steeper curve may actually accelerate coupon compression in 30-years by sustaining fast speeds on high premiums," researchers at the firm wrote.

In other words, even a Fed ease resulting in a steeper curve would not save premiums. Dollar prices are high enough and the increase in paydowns resulting from a steeper curve will more than offset the benefits of lower discount rates.

Analysts at the firm expect coupon compression to continue to be a factor especially as the market discounts extension risk and starts to be more concerned about income.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

(http://www.thomsonmedia.com)

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